Solution to Problem Set 1 - Solution to Problem Set 1:...

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Unformatted text preview: Solution to Problem Set 1: Question 1-6: From Chapter 1, problems 2, 4, 7, 9, 11, and 12. P1‐2. Suggested solution (4 points): An IPO is a sale of a part of the entrepreneur’s company to other investors. Inherently, there is uncertainty about the future success of this company and the value of the company’s shares in the future. Potential investors demand information to reduce this uncertainty. If the entrepreneur is able to supply information that reduces the potential investor’s perceptions of uncertainty, she is likely to be able to obtain a higher stock price in the IPO. The entrepreneur has intimate knowledge of her company’s operations, which is likely to be far superior to the information available to potential buyers of the IPO shares—there is information asymmetry between the entrepreneur and potential investors. P1‐4. Suggested solution (6 points, 0.5 point for each cell): Adverse selection Moral hazard Hidden information Hidden action Information about past, present, or future? Past and present Future Associated with the market for “lemons” or insurance deductibles? Market for lemons Insurance deductibles Full disclosure Risk sharing Most closely associated with investment decisions or compliance with contractual terms? Investment decisions Compliance with contractual terms Creates demand for provision of relevant or reliable information? Relevant information Reliable information Hidden action or information? Mitigation of information asymmetry involves risk sharing or full disclosure? P1‐7. Suggested solution: (8 points) * This scenario is an example of an agency relationship that gives rise to moral hazard. * The taxi driver is agent of the taxi company. * The driver has an information advantage over you (the passengers/visitors) regarding the geography of the city. * The driver also has an information advantage over the management and owners of the taxi company regarding the minute‐to‐minute operations of the taxi. * The fare meter is a device to mitigate these two information asymmetries. It is an indirect monitoring device for the taxi company to track how the taxi driver is operating the taxi. It also provides incentives for the driver to take passengers using an efficient route. (Note that the fare increases for both distance travelled and time, so there is more reward when the taxi is moving rather than idling, and more reward when it moves faster.) * An assumption we take for granted, but which is nonetheless important, is that the driver’s pay is directly linked to the taxi fare. * The meter does not eliminate moral hazard problems. It is only an indirect monitor of driver behaviour and tracks a limited number of items. If the driver is unfriendly or drives recklessly, the meter would not capture that information. * The metered fare also does not preclude a driver taking a circuitous route to increase the distance travelled and thus increasing the fare. Many cities require taxi cabs to post estimated fares from the airport to popular destinations such as downtown so that taxi drivers do not take advantage of visitors who are not familiar with the city’s geography. * Providing a gratuity at the end of the trip is a separate practice that helps to mitigate the moral hazard problem: the passengers serve as the monitors of the driver’s behaviour. * For the meter system to be useful, the taxi company and passengers must be confident of its reliability. A meter that can be easily tampered with by the driver will provide misleading information to these users. P1‐9. Suggested solution (8 points): Fixed salary: * Does not motivate management; only if the manager’s actions can be observed would a salary be optimal. * Agency theory predicts that the manager will shirk because of self‐interest. * Shirking occurs because there is moral hazard: the owners cannot observe the manager. * Information will be more reliable, but the company would be worth a lot less. * There is a trade‐off between reliable information and maximizing firm value. Stock options: * Manager still has incentive to bias information to try to affect stock price. * Option compensation has higher risk than bonuses because stock price is affected by factors outside the manager’s control and not reflective of his/her effort. * Manager needs to be paid more to compensate for the additional risk. * Could lead to more insider trading and more incentive to withhold information from shareholders. * Insider trading is costly to outside investors. P1‐11. Suggested solution (8 points) * The provision of both auditing and non‐audit services creates a conflict of interest for accounting firms. * Auditors need to be independent and objective in evaluating companies’ financial statements, but consultants are interested in helping companies become successful. * Auditors may compromise their independence to maintain/attract profitable consulting business. * Without an independent audit to verify numbers, a firm’s financial statements become unreliable. * Investors will become skeptical of reported results, increasing adverse selection. Skeptical investors will pay less for firms’ securities (equity or debt), thereby increasing the cost of capital. * The regulation requiring fee disclosure could solve the adverse selection problem: investors will be able to infer from fees paid to what extent audit independence may have been compromised (more non‐audit fees = higher risk). * As a result, companies that report more non‐audit fees will be viewed as “lemons” as it will be difficult to convince investors otherwise, and their cost of capital will rise. * Companies will therefore voluntarily reduce the use of accounting firms for non‐audit services to lower their cost of capital. * Thus, the disclosure regulation could be viewed to be in the public’s best interest. * Additional regulation requiring the separation of audit and non‐audit divisions would be unnecessary. P1‐12. Suggested solution: (6 points) * The theory of efficient security markets (EMH) applies to commodities as much as to stocks. * Investors cannot make superior returns consistently if the markets are efficient. * It is probably more difficult to “spot the home‐run play” in the commodities market— there are many more buyers and sellers for each commodity (only 20 commodities) than in the stock market. * Basic economics tells us that commodity markets, having many buyers and sellers, are nearly perfect. * There could be more risk in commodities, explaining the higher returns. Systematic risk could be higher—many commodity prices move together because of weather and the economic cycle. * If the brochure provides inside information, you could make superior profits. However, this brochure is widely circulated, and if many others have already bought into this system there is unlikely to be any inside information left. Question 7 Jenny operates a small, fast‐growing internet firm. Her workload has expanded to the point where she decides to hire a full‐time manager. Jenny is considering Henry as the manager for the firm. She ascertains that Henry is risk averse, with utility for money equal to the square root of the dollar compensation received. Henry already has a job offer that yields him an expected utility of 6. He is willing to accept an expected utility of 6 or higher from Jenny. Henry is also effort averse, with a disutility of effort of 3 if he works hard and 2 if not. In the past, Jenny’s business has earned net income (before manager compensation) of $900 for 75% of the time, and income of $0 for 25% of the time. Jenny always worked hard, and if she did not work hard, net income would have been $900 for only 20% of the time and $0 for 80% of the time. She expects this earnings pattern to continue into the future with a new manager. Jenny offers Henry compensation based on a proportion of reported net income. a) What is the minimum proportion of net income must Jenny offer Henry so that he will accept the position and work hard? Show calculations (6 pts. for complete answer, 2 for just setting up the correct equation) Let the proportion of net income be x. Then we want: Expected Utility (work hard) = 0.75 √900x + 0.25 √0 − 3 = 6 = 0.75 × 30√x + 0 − 3 = 6 or, 22.5 √x = 9 From which: x = 0.16 In order to have Henry accept the offer and work hard, Jenny should offer at least 16% of the net income to Henry. b) Having signed a 1‐year contract with the offer from part a, Henry soon realizes that he can effortlessly manage earnings so as to ensure that net income of $900 is reported for this year (i.e. with 100% probability that net income of $900 will be reported), even if he does not work hard. Give two reasons why a manager who may be tempted to shirk and cover up by opportunistic earnings management would not do so. Explain your reasons. [4 points total, 2 points for each reason] • Henry may be concerned about damage to his reputation if the opportunistic earnings management is discovered. This would lower his reservation utility. • Henry may behave ethically, on the grounds that unethical behaviour is not in his longer‐term interest or in that of the profession. • Jenny may hire an auditor. If so, the earnings management may be revealed. • Internal monitoring is high and Henry does not have opportunity to manage earnings. Note: Any two reasons, if reasonably explained, are adequate for full marks. ...
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This note was uploaded on 02/21/2011 for the course COMM 353 taught by Professor Jennyzhang during the Winter '10 term at The University of British Columbia.

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